Federal Reserve Governor’s Speech on Macroprudential Regulation

Governor Daniel K. Tarullo At the Yale Law School Conference on Challenges in Global Financial Services, New Haven, Connecticut September 20, 2013 – Macroprudential Regulation

“Real world crises have a way of shaking up the intellectual foundations of policy disciplines. Elements of received wisdom are undermined, while certain heterodox or less mainstream views are seen as more valid or important than had been widely recognized. The financial crisis of 2007-2009 was no exception. Some ideas, such as the efficient markets hypothesis, have taken some hits, as others have risen to prominence. An example of the latter is the view that financial stability must be an explicit economic policy goal. A corollary of this view is that a “macroprudential” perspective–generally characterized as focused on the financial system as a whole as opposed to the well-being of individual firms–should be added to traditional prudential regulation. A single speech cannot hope to touch on, much less do justice to, the many theoretical and policy issues encompassed by the term macroprudential. In my remarks this afternoon I will focus principally on the project of recasting the regulation and supervision of large financial firms so as to realize the macroprudential objective of reducing systemic risk. Specifically, I will offer five propositions that I think should guide this project over the next couple of years. In so doing, I will explain some of the key steps that have already been taken and identify some priorities that remain, though even here I do not pretend to comprehensiveness. Before addressing the macroprudential dimension of regulating large financial firms, however, let me provide some context by briefly reviewing the evolving idea of macroprudential policy.

Macroprudential Policy
Although the crisis and its aftermath have created a broader consensus for the proposition that financial stability should be a more explicit objective of economic policy, there is considerably less convergence around theories of, metrics for, and policy prescriptions to promote, financial stability. Policy and academic writing generally limits the term “macroprudential” to measures directed specifically at countering risks in the financial system that, if realized, can severely impact real activity. But adoption of consistent terminology does not itself resolve questions of whether, for example, increases in systemic risk are endogenous to the financial system and thus follow a somewhat regular cyclical pattern, or are instead somewhat randomized, albeit repeated, phenomena. Differences in views of the origins of systemic risk obviously affect views of the best ways to measure it and, of course, the best policies to contain it. One example, of particular interest to central bankers, is the ongoing debate about the circumstances under which monetary policy should be adjusted to take account of financial stability concerns. Lying behind the various positions in this debate are differing views on how systemic risk propagates, and thus on the relative efficacy of monetary versus macroprudential policies. Progress in these debates is complicated by the fact that, by definition, financial stability policies are directed toward preventing or mitigating rare events, rather than outcomes such as inflation and unemployment that are continuously observable. This focus on tail risks raises important issues of accountability in the institutional design of macroprudential policies and also complicates the task of testing financial stability theories and proposed policies. Yet even against the backdrop of what is still a comparatively underdeveloped understanding of financial stability, commentators and policymakers have compiled and, in some cases, developed so-called “toolkits” of possible macroprudential measures. These measures are thought available for use against one or both of two frequently identified dimensions of systemic risk: procyclicality and interconnectedness. Of course, the attractiveness of many of these tools will depend on one’s views of a variety of theoretical, institutional, and practical questions. The tools identified can be variously categorized. One useful distinction is between measures designed to prevent systemic risk from building (often termed “lean-against-the-wind” measures) and those designed to increase the resiliency of the financial system should systemic risk nonetheless build sufficiently that broad-based stress ensues. Another distinction is between time-varying and time-invariant measures, with the former based on a response–either discretionary or in accordance with a rule–to some measured increase in risk.”

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